Moving Beyond the Supercommittee: Schwab Responds

Despite challenges, Schwab remains optimistic

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The Schwab Center for Financial Research released a statement, “Beyond the Supercommittee,” late Tuesday following the Joint Select Committee on Deficit Reduction’s failure to reach an agreement on how to reduce the debt over the next 10 years. The committee’s deadline for a resolution was Nov. 23, but members were required to release to the public their recommendations by Monday, Nov. 21.

As a result, automatic cuts that will trim $1.2 trillion, $2 billion of which will be from savings on interest on the debt, will take effect Jan. 3, 2013. Those cuts will be spread out over the next nine years, and will be taken equally from defense and non-defense spending. Social Security, Medicaid, veterans' benefits, children's health programs and the Earned Income Tax Credit are exempt from any cuts.

Schwab notes, though, that with more than a year before these “automatic” cuts begin, there’s plenty of time for Congress to undo them. “A number of members of Congress from both sides of the aisle have said that they will make attempts in the coming year to reduce or eliminate many of the planned cuts.”

For businesses, a research and development tax credit is set to expire at the end of the year, as well as the 2011 payroll tax cut, which reduced the amount of payroll taxes taken out of employees’ checks to 4.2%. Extending that cut for another year would cost $100 billion. A proposal by President Barack Obama to reduce the tax again to 3.1% would cost about $245 billion.

For individuals, deductions for state and local sales tax, college tuition and the IRA charitable rollover are set to expire at the end of the year. Looking further ahead, the Alternative Minimum Tax patch that increased the exemption from the AMT is in place for the 2011 tax year.

The biggest issue, though, is that the Bush tax cuts will expire at the end of 2012. “Congress will need to deal with those before the end of 2012,” Schwab notes. ”There is a good chance that Congress will wait until after the 2012 elections to address the issue, in what is known as a ‘lame duck’ session of Congress in November/December 2012. That's what happened in 2010, when Congress waited until December 17th before passing a two-year extension of the tax cuts.”

Following the supercommittee’s failure to meet its first deadline on Monday, market action was “grim,” according to Schwab, but the company noted that the eurozone crisis could be as much at fault.

Regardless of the cause, though, it does add to the “confidence crisis” investors have suffered from.

“The market continues to resemble a see-saw, moving from risk-on to risk-off mode, depending on news flow. After a nearly 10% rally in the first four months of the year, the market suffered a near-20% correction over the next five months, before rallying a big 17% in October. Since then, the market has been consolidating some of those gains.”

Schwab believes there are sufficient positive influences to keep the market in a trading range with an upward bias. For instance, weekly unemployment insurance claims were below 400,000 for the third straight week, while layoffs fell and job postings increased. Bank lending among consumers and businesses is on the rise, and optimism is slowly increasing among banks and consumers alike.

Nine of the 10 leading economic indicators that make up The Conference Board’s Leading Economic Index are up. Inflation and housing news is also improving.

That’s just in the United States. Schwab is confident that global influences won’t drag down U.S. stocks. While a eurozone recession is “likely,” trade with Europe only accounts for 1.3% of GDP.

That’s not to say it’s all good news. Oil prices are climbing on continued tension in the Middle East and market volatility continues to keep investors out of the market. Speaking at Schwab Impact 2011 in San Francisco earlier this month, LizAnn Sonders, (left), chief market strategist for Schwab, told attendees, “We have to face the fact that the movers of the market tend to be high frequency traders.” She worried that “the market is more reactionary than it's ever been before, and is not playing its proper role.”

Also adding to Schwab’s bearish outlook is the risk that another U.S. recession hasn’t be completely eliminated; a downward revision to third-quarter GDP “adds fuel to that view. Finally, the supercommittee’s failure should not be overlooked.

Despite these challenges, Schwab is still convinced that the positive factors will bear more weight on the economy than the negative factors.

“Admittedly, the bearish case is the more intellectually powerful and will continue to put pressure on the US economy and markets,” the company wrote. “But we believe much of it is already built into expectations (and prices). When the expectations bar gets set as low as it has been, the ability for results to hurdle that bar becomes easier.”

Schwab points to October’s market rally as evidence that “you don't need a rash of exceptionally good news—just marginally better news than the consensus expects—to pull some of the massive sidelined money back into the market.”

Should Congress fail to undo the expected automatic cuts, the defense sector will be the riskiest industry “by far,” as it’s facing up to $900 billion in cuts, according to a Strategas Group report cited by Schwab. While military officials and members of Congress on both sides of the aisle have criticized cuts to defense spending, the president has said he would veto attempts to undo those cuts.

Health-care companies that work with the government are also at risk. Strategas estimated companies that provide Medicare services could lose $120 billion.

For now, rating agencies don’t appear to be in any hurry to downgrade the United States’ debt rating. Following the announcement of the supercommittee’s failure, Standard & Poor's, Moody's Investors Service and Fitch Ratings reaffirmed their current ratings, according to Schwab.

Nevertheless, Treasury yields are trading at 40-year lows, Schwab writes, and the United States continues to receive inflows of foreign capital. “Even with downgrades, the market action suggests that the US Treasury market remains the benchmark for global investors. We believe that the market will determine interest rates on US debt, not the rating agencies.”

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